The Devil’s Invention

June 27, 2011

thedevilsinventionIn "The House That Bogle Built," journalist Lewis Braham digs into the details of the life of the man known as the father of indexing and to many as "Saint Jack." The book follows Bogle from his tumultuous childhood through the founding of one of the world's best-known mutual fund companies to his ouster from his own company and rebirth as an investor advocate. What follows is an excerpted version of Chapter 11, which recounts the development and rise of Vanguard's indexing business and the advent of the ETF boom.

Vanguard launched the first index mutual fund, appropriately named First Index Investment Trust, in August 1976. Later, the name was changed to Vanguard 500 Index Fund. The company was not, however, the first money manager to track an index or even the S&P 500. But if you say to Jack Bogle that he created the first retail index fund, he'll holler, "No, no, no, no; don't use the word 'retail'! This is the first index mutual fund—period!" Although he readily admits that he wasn't the ur-indexer, he has, to put it mildly, a lot of pride in the invention, and certainly without him it's hard to imagine the index fund ever getting off the ground with the general public. The concept may have stayed within the rarefied field of academia or remained the exclusive province of institutional investors.

But the indexing idea had been kicked around for a long time before Vanguard launched its famous fund. Bogle himself had stated in his 1951 Princeton thesis that, "Funds can make no claim to superiority over the investment averages, which are in a sense investment trusts with fixed portfolios," although in the very same work he would go on to explain the benefits of actively managed funds. In fact, in 1960, when two University of Chicago finance wonks published an article titled "The Case for an Unmanaged Investment Company" in the Financial Analysts Journal, Bogle published a rebuttal titled "The Case for Mutual Fund Management" a few months later, using the pen name John B. Armstrong so as to avoid getting his employer, Wellington Management, in trouble with the SEC. In it he detailed how four unnamed funds—one of which was Wellington Fund—had beaten the Dow Jones industrial average for 30 years with less volatility than the market.1

The first indexed account was created by William Fouse and John McQuown at Wells Fargo Bank in 1971. Because at the time the Glass-Steagall Act prohibited banks from managing mutual funds, Wells Fargo could not launch an index fund for individual investors. So instead, Wells Fargo started to run institutional index money in a private $6 million account for Samsonite, the luggage manufacturer. Problems immediately resulted, though, because the benchmark Wells Fargo decided to track was the New York Stock Exchange, and McQuown and Fouse chose to equal-weight each of its 1,500 stocks. To maintain an equal position size in each stock required a great deal of turnover, and transaction costs consumed too much of the returns as a result. So in 1973, Wells Fargo switched to the S&P 500, a low-turnover market-cap-weighted index. Money manager Batterymarch Financial Management and the American National Bank in Chicago created similar indexed accounts for institutions at around the same time.

Although he always thought that most managers would lag the index, Bogle became a real convert in 1974 after reading an article titled "Challenge to Judgment" by famed economist Paul Samuelson in the Journal of Portfolio Management. In the article, Samuelson pleaded for someone to start an index fund for retail investors. Bogle then read Charles Ellis' article "The Loser's Game" the following year, which outlined the basic argument for indexing: Professional money managers now were the market in aggregate and would lag it after deducting their fees.2 Ellis would later join Vanguard's board of directors.

As it happened, the timing to create an index fund couldn't have been better for Bogle. He had just launched Vanguard in May 1975 and was looking to internalize the advisory function of the mutual funds as one of the steps in "cutting the Gordian knot" that tied Vanguard to Wellington Management. "The biggest problem was selling it to Vanguard's board of directors because we had agreed not to get into investment management," says Bogle. "So I said, 'This fund didn't have a manager.' The directors bought that. Of course, technically, it's true. The fund is unmanaged." Former and present Vanguard index fund managers Jan Twardowski, George "Gus" Sauter, and Michael Buek might beg to differ, and Bogle himself would later say of his unmanaged fund pitch, "It was one of the greatest disingenuous acts of opportunism known to man."3 Even index funds need a manager to make sure that the assets are invested appropriately.

Although he may have had some ulterior motives for starting the fund, certainly Bogle believed that indexing would produce the best results for investors. "We started operations in May 1975 and I had the proposal for the index fund on the directors' desk in June of 1975—the first thing we did," he says. "Then the idea had to be sold to the directors, sold with data." Bogle crunched the numbers himself, calculating returns for the average mutual fund for the past 30 years versus the S&P 500 and proving that the index had an edge of 1.6 percentage points a year. "That was the evidence I needed to persuade the directors," he says. "I didn't need any persuasion myself." In May 1976, Vanguard's board approved the filing of the First Index Investment Trust's prospectus.

But convincing the board was only the first step. Bogle also had to sell the index fund concept to investors and Wall Street itself. The reaction within the fund industry after the 1976 launch was decidedly negative: "the pursuit of mediocrity," one commentator called it; "un-American," said another; "the devil's invention," said a third; "a formula for a solid, consistent, long-term loser," said a fourth. Despite the naysayers, Bogle ultimately persuaded Dean Witter to lead an underwriting of the new fund. He'd hoped for $150 million, but it took three months to raise the $11 million that formed the initial base for the fund. By the end of 1976, the fund had grown to only $14 million. It was not going to be easy to convince investors to put their money into a fund that would merely match the market; investors wanted to beat the market.


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